Micro Ch 5

© 2015 Pearson Education, Inc.

Chapter 5Consumers and

Incentives


Chapter Outline

5.1 The Buyer’s Problem5.2 Putting It All Together5.3 From the Buyer’s Problem to the Demand Curve 5.4 Consumer Surplus5.5 Demand Elasticities

5 Consumers and Incentives


Key Ideas

1. The buyer’s problem has three parts: what you like, prices, and your budget.

2. An optimizing buyer makes decisions at the margin.

3. An individual’s demand curve reflects an ability and willingness to pay for a good or service.



Key Ideas

4. Consumer surplus is the difference between what a buyer is willing to pay for a good and what the buyer actually pays.

5. Elasticity measures a variable’s responsiveness to changes in another variable.




Evidenced-Based Economics Example:

Would a smoker quit the habit for $100 a month?

= incentives

What would motivate you?



Why does the demand curve have a negative slope?



Why does a soda machine only dispense one bottle or can at a time, but a newspaper vending machine opens up so that you can take as many as you want?


5.1 The Buyer’s Problem

The Buyer’s Problem:

1. What do you like?2. How much does it

cost?3. How much money

do you have?


5.1 The Buyer’s ProblemWhat You Like: Tastes and Preferences

What do you like?

Everyone has different likes and dislikes, but we assume everyone has two things in common:

1. We all want the “biggest bang for our buck”2. What we actually buy reflects our tastes and

preferences


5.1 The Buyer’s ProblemPrices of Goods and Services

How much does it cost?

We also assume two characteristics of prices:

1. Prices are fixed—no negotiation2. We can buy as much as we want of something

without driving the price up (because of an increase in demand)


5.1 The Buyer’s ProblemHow Much Money You Have to Spend: The Budget Set

How much money do you have?

There are lots of things to do with your money, but we assume:

1. There is no saving or borrowing, only buying2. That even though we use a straight line to

represent purchase choices, we only purchase whole units



Exhibit 5.1 The Budget Set and the Budget Constraint for Your Shopping Spree



Why does the budget line have a negative slope?



What does the slope represent?


5.2 Putting It All Together

Suppose Bill Gates offered to buy you a Jaguar—a $100,000 car.

Would you accept his offer?



The next day, he calls and says he doesn’t have time to buy the car and will just give

you a check for $100,000 instead.

Will you go buy the car?



Exhibit 5.2 Your Buyer’s Problem ($300 available)



Exhibit 5.2 Your Buyer’s Problem ($300 available)



Consumer Equilibrium Condition:

MBs = MBj Ps Pj

What if MBs = $75 and MBj = $100?


5.2 Putting It All TogetherPrice Changes



Exhibit 5.3 An Inward Pivot in the Budget Constraint from a Price Increase



Exhibit 5.4 A Rightward Pivot in the Budget Constraint from a Price Decrease



Consumer Equilibrium Condition:

MBs = MBj Ps Pj


5.2 Putting It All TogetherIncome Changes

Exhibit 5.5 An Outward Shift in the Budget Constraint from an Increase in Income








5.3 From the Buyer’s Problem to the Demand Curve

Sweaters $25 Jeans $50Quantity Total

Benefits

(A)

Marginal Benefits

(B)

Marginal Benefits

per Dollar Spent =(B) / $25

Total Benefits

(C)

Marginal Benefits

(D)

Marginal Benefits

per Dollar Spent =(D) / $50

Marginal Benefits

per Dollar Spent =(D) / $75

0 0 0 1 100 100 4 160 160 3.2 2.132 185 85 3.4 310 150 3 23 260 75 3 410 100 2 1.334 325 65 2.6 490 80 1.6 1.075 385 60 2.4 520 30 0.6 0.46 435 50 2 530 10 0.2 0.137 480 45 1.8 533 3 0.06 0.048 520 40 1.6 535 2 0.04 0.039 555 35 1.4 536 1 0.02 0.01

10 589 34 1.36 537 1 0.02 0.0111 622 33 1.32 538 1 0.02 -0.0212 654.5 32.5 1.3 539 1 0.02 -0.07



Exhibit 5.6 Your Demand Curve for Jeans



Why does the demand curve have a negative slope?



Why does a soda machine only dispense one bottle or can at a time, but a newspaper vending machine opens up so that you can take as many as you want?


5.4 Consumer Surplus

How much are you willing to pay for an A?



Consumer Surplus

The difference between what you are willing to pay and what you have to pay (the market price)



Exhibit 5.7 Computing Consumer Surplus



Exhibit 5.8 Market-Wide Consumer Surplus


5.4 Consumer SurplusAn Empty Feeling: Loss in Consumer Surplus When Price

Increases

Exhibit 5.9 Market-Wide Consumer Surplus When Prices Change



Evidenced-Based Economics Example:

Would a smoker quit the habit for $100 a month?

= incentives

What would motivate you?



Exhibit 5.10 Experimental Results from Smoking Study



Your Buyer’s Problem with an Extra $100 ($300 → $400)




5.4 Demand Elasticities

Why are last-minute airplane tickets so expensive?

Why are last-minute Broadway show tickets so cheap?



Suppose you play in a band. Your band has a steady gig with a bar that gives you the cover charge without taking a cut. You and your band are interested in increasing the money you make from this gig and are talking about changing the cover charge.

Should you increase it or decrease it?



Elasticity

A measure of how sensitive one variable is to changes in another



Three measures of elasticity:

1. Price elasticity of demand2. Cross-price elasticity of demand3. Income elasticity of demand


5.4 Demand ElasticitiesThe Price Elasticity of Demand

1. Price elasticity of demand answers the question:

How much does quantity demanded change when the good’s price changes?

Mathematically: the percentage change in quantity demanded due to a percentage change in price:


5.4 Demand ElasticitiesPrice Elasticity of Demand

Jeans example from Exhibit 5.6:

The lowest price was $25, and the optimal quantity was 4 pairs.

The second price was $50, and the optimal quantity was 3 pairs.

Quantity decreased by 25% ((4-3)/4) when price increased by 100% ((25-50)/25), so

ED = -25%/100% = -0.25


5.4 Demand ElasticitiesElasticity Measures

ED > 1 = Elastic

ED < 1 = Inelastic

ED = 1 = Unit Elastic

ED = ∞ = Perfectly Elastic

ED = 0 = Perfectly Inelastic



Exhibit 5.13 Examples of Various Price Elasticities



Let’s look at another point on the demand curve for jeans:

Original price = $25; original quantity = 4 pair

What if price increased to $30 (20% increase) and as a result, the optimal quantity fell to 3 (25% decrease)

ED = -25%/20% = -1.25



Suppose you play in a band. Your band has a steady gig with a bar that gives you the cover charge without taking a cut. You and your band are interested in increasing the money you make from this gig and are talking about changing the cover charge.

Should you increase it or decrease it?



TR = P x QIf demand is inelastic, when price increases,

quantity decreases—a little: TR = P x Q = TR

The price increase pushes total revenue up, the quantity decrease pushes total revenue down, but

the price increase is more than the quantity decrease, so the final result is that total revenue

increases.



TR = P x QIf price decreases, total revenue also decreases.

As a result of the lower price, quantity increases, but because demand is inelastic, quantity

increases only slightly. The net result on total revenue is that it decreases.

TR = P x Q = TR


5.4 Demand ElasticitiesDeterminants of the Price Elasticity of Demand

Determinants:

• Number and closeness of substitutes• Budget share spent on the good• Time horizon available to adjust to price

changes


5.4 Demand ElasticitiesDeterminants of the Price Elasticity of Demand

Why are last-minute airplane tickets so expensive?

Why are last-minute Broadway show tickets so cheap?


5.4 Demand ElasticitiesThe Cross-Price Elasticity of Demand

2. Cross-price elasticity of demand answers the question:

How much does the quantity demanded of one good change when the price of another good changes?

Mathematically: the percentage change in demand of good 1 due to a percentage change in the price of good 2:


5.4 Demand ElasticitiesThe Cross-Price Elasticity of Demand

Exhibit 5.14 Examples of Various Cross-Price Elasticities


5.4 Demand ElasticitiesThe Income Elasticity of Demand

3. Income elasticity of demand answers the question:

How much does quantity demanded change when income changes?

Mathematically: the percentage change in demand of a good due to a percentage change in income


5.4 Demand ElasticitiesThe Income Elasticity of Demand

Exhibit 5.15 Examples of Various Income Elasticities

Economy & Finance

Micro Ch 5